What s Economics about?

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Clifford Sharp
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1 Fernando Branco Fall Quarter Session 1 1st Part What s Economics about? Science of making decisions to allocate scarce resources to alternative uses. Three fundamental questions: What? How? To whom? Microeconomics vs Macroeconomics. A market economy Goods and Services Families Government Organizations Production Factors Real flow Money flow 1

2 Microeconomics vs Macroeconomics Microeconomics: Studies decision making and interactions of individual agents; Concentrates on Demand, Supply and Markets. Macroeconomics: Studies the evolution of the aggregate economy, as a result of individual decisions and interactions; Concentrates on Product, Unemployment and Inflation. Why? Organizations Factor Markets Manager Product and Services Markets Government The Fundamentals of Managerial Economics Identify objectives and constraints; Conduct marginal analysis; Use economic profits; Consider incentives and signaling; Understand markets; Recognize the time value of money. 2

3 Identify objectives and constraints The role of objectives: Choices are made to achieve objectives; Objectives of the unit and objectives of the sub-units. Resources are scarce: Impose constraints; Limit possibilities. Conduct marginal analysis Why and how marginal analysis: Decide on the basis of marginal benefits and marginal costs. Examples: Discrete decisions: How many machines to buy? Continuous decisions: How much for advertising? How many machines to buy? Mach. Benefits Costs Marginal Marginal Benef. Cost

4 How much for advertising? Benefits: 2 B( a) = a a Costs: C ( a) = a Marginal Benefits: MB( a) = 2 2a Marginal Costs: MC( a) = 1 Optimal Decision: MB ( a) = MC( a) 2 2a = 1 a = 0. 5 Use economic profits Accounting profits Economic profits: Oportunity costs. Example: Operation of a small pizzeria. Objective: maximize shareholders value. Operation of a small pizzeria (I) Mike runs a small pizzeria in his hometown. He owns the building. Annual revenues are euros. Annual costs are Annual profit is euros. This is not the economic profit! 4

5 Operation of a small pizzeria (II) Mike could have a job earning Mike could have rented the space for The economic profit is just: Π = = CONCLUSION: Mike should close the pizzeria, rent the space and get the alternative job. Consider incentives and signaling People respond to incentives: Incentives must be aligned with objectives. Example: Empirical effects of performance contracts. People s decisions are signals of their information. Example: The legend of Deuladeu Martins. Empirical effects of performance contracts China has used performance contracts on a large scale. On average, they were negative because of large losses on poorly designed PCs. Successful PCs were those with sensible targets, stronger incentives, longer term, managerial bonds, and in more competitive industries. M. Shirley and L. Xu, Empirical effects of performance contracts: Evidence from China, Journal of Law, Economics and Organization 17(1), April,

The legend of Deuladeu Martins Siege of Monção by the Castilian army in 1376. Deuladeu Martins ordered that the bread baked from the last flour in the village, to be thrown to their besiegers.

6 The legend of Deuladeu Martins Siege of Monção by the Castilian army in Deuladeu Martins ordered that the bread baked from the last flour in the village, to be thrown to their besiegers. Inferring that the villagers had plenty of supplies, the siege was lifted. Understand markets It takes two to tango: demand and supply. Conflicting interests between buyers and sellers. Rivalry among buyers: Auctions. Rivalry among sellers: Mobile communications. Government and the markets Understanding markets is key for good management decisions. Recognize the time value of money Many decisions have monetary implications througout a long period of time (R&D is a typical example). This raises specific problems. 1 today is worth more that 1 one year from now. Opportunity cost of capital; Use present values. Example: R&D of new drugs. 6

7 R&D of new drugs The development of new drugs is lenghty and costly: 12 years and 802M$ on average (Di Masi et al, J. of Health Economics, 2003). This is a huge investment. Pharmaceutical companies attempt only to develop drugs with very high expected revenues. The result is that no new drugs are developed for typical third world diseases (Economist, 99/08/14). Structure of the Course Information on the course homepage 7

- A person who directs resources to achieve a stated goal. - The science of making decisions in the presence of scarce resources.

- A person who directs resources to achieve a stated goal. - The science of making decisions in the presence of scarce resources. The Fundamentals of Managerial Economics: Overview Basic premise of this course: Study managerial decisions as they relate to maximizing profits, or more generally, the value of the firm. Fundamental principles